GERMANY Law and Practice Contributed by: Michael Josenhans, Lucas Lengersdorf and Karl Kuhn, Freshfields
scenarios. Mezzanine financing blends subordi - nated or unsecured debt with equity-related fea - tures such as warrants. Subordinated loans rank below senior debt in repayment priority, offering higher yields, while profit-participating loans tie returns to the borrower’s performance. Convert - ible instruments allow debt to convert into equity under specific conditions, aligning lender returns with the company’s growth potential. HoldCo payment-in-kind (PIK) financings are also seen in certain transactions, enabling borrowers to defer interest payments and conserve cash flow. Notable documentary features include a so- called anti-layering-covenant which precludes the borrower from incurring new subordinated debt, layered between the senior and subordi- nated tranches, hence ensuring that the subordi - nated debt will only be junior to the current sen - ior tranches. Another prominent provision is the prohibition on making short-circuit payments. This provision has two purposes, ensuring on the one hand, that no shareholder contribution will be structurally senior to the HoldCo financ - ing and, on the other, that distributions made upstream are funnelled through the HoldCo entity. Other features in subordinated financing agree - ments are subject to negotiation, such as a potential covenant-look-through to the operat - ing company (OpCo) group as well as events of defaults and their scope with a view to the OpCo group or material subsidiaries thereof. Further, the granting of certain information and/ or participation rights (eg, by way of designated board-members or observers) is frequently dis - cussed. Such information and/or participation rights would, however, need to be assessed critically, especially with a view to corporate governance, confidentiality and equitable sub - ordination aspects. Additionally, junior lenders
may want to have the option to cure payment/ financial covenant defaults on OpCo level (so called step-in rights). See 5.1 Assets and Forms of Security for dis- cussion of the customary scope of collateral. 3.8 Payment in Kind/Amortisation In Germany, PIK arrangements in private debt are not particularly common in traditional mar - kets but have become more frequent in high- yield, distressed or leveraged finance transac - tions, especially in private equity-backed deals. PIK loans allow borrowers to defer interest pay - ments, which are instead capitalised into the principal. This structure can be attractive for borrowers looking to preserve cash flow during growth or restructuring phases. But, pursuant to Section 248 paragraph 1 of the German Civil Code ( Bürgerliches Gesetzbuch – BGB), the par - ties to a loan governed by German law may not agree upfront to compound interest (ie, inter - est may not be charged on interest) but can do so once the interest has accrued (ie, PIK tog - gle arrangements are possible, but may require certain procedural steps to ensure compliance Call protections conflict with the circumstance that, by law, the borrower can terminate loans with variable interest rates at any time with a notice period of three months in accordance with Section 489 paragraph 2 of the BGB. Loan agreements with a fixed interest rate can be can - celled at the end of the fixed interest period and after ten years at the latest, according to Section 489 paragraph 1 of the BGB. Any prepayments which are made prior to the last day of the cur - rent interest period, will generally trigger break costs under German law. with mandatory law). 3.9 Call Protection
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